SPEASchool of Public and Environmental Affairs Insights(SPEA) • Indiana University May 2010

Bailing Out Underwater Mortgages

Summary The ongoing mortgage crisis has produced profound changes in the economic conditions of American families and destabilized global financial markets. Millions of homeowners are currently “underwater” on their mortgages – that is, they owe more on their mortgages than their homes are worth. The federal government has taken unprecedented steps to intervene in the crisis, both to reduce family hardship and to curb insolvency among financial institutions. The nearly trillion-dollar federal policy response to the crisis represents the broadest economic intervention since the Great Depression. Yet Ashlyn Aiko Nelson, as mortgage delinquencies and home foreclosures continue to rise, there is growing public Assistant Professor, concern that these interventions were insufficient and the end of the crisis is nowhere in School of Public and Environmental Affairs sight. [email protected] What are underwater mortgages, and why are they a public policy concern? Underwater homeowners are of particular concern because they are more likely to The views expressed are solely those of the default on their mortgages. First, households with mortgages worth more than their author and do not imply endorsement by homes are unable to refinance their way out of the high-cost mortgages they can no longer Indiana University or the School of Public and afford. Second, even households who could afford to continue paying their mortgage may Environmental Affairs. choose to strategically default, and walk away from their homes when there is no equity left to preserve (Geanakoplos and Koniak 2009; Foote et al. 2008). Some economists project that housing prices will continue to fall in 2010, increasing mortgage defaults by pushing more homeowners underwater and deepening the negative equity position for those already underwater (Christie 2010). At a micro level, mortgage defaults and home foreclosures exacerbate financial hardships for families, result in residential displacement and community instability, depress local housing prices, and increase the need for social services. At a macro level, mortgage defaults reduce solvency among financial institutions, constrain the availability of credit, and slow economic growth. The federal government now has the unenviable task of designing policies to keep underwater mortgages from undermining economic recovery.

Peer Reviewers: Kim Rueben, The underwater mortgage crisis: How did it happen, Senior Research Associate, Tax Policy Center, and where are we now? Urban Institute and Ingrid Gould Ellen, In the first half of the last decade, homeownership opportunities expanded quickly Professor of Public Policy and Urban for several reasons: low interest rates, rapid housing price appreciation, expansionary Planning, NYU Wagner Graduate School of Public Service and Co-Director, Furman mortgage policies, growth in the secondary mortgage market, and improved access to credit Center for Real Estate and Urban Policy among traditionally underserved borrowers. Housing prices then declined after peaking in mid-2006, triggering a wave of defaults among borrowers. By others place the estimate as high as one in four (First American the end of 2009, American households had lost $7 trillion in real CoreLogic 2010; The Economist 2010). estate wealth, 13.6 percent of all U.S. mortgages were in a state of The problem is even worse among households that purchased delinquency, and nearly 1 in 20 borrowers – more than 5 million homes in the last five years, with 29 percent (nearly one in three households – were 90+ days delinquent and at risk of foreclosure households) underwater (Hagerty and Simon 2008). Among (Office of the Comptroller of the Currency and Office of Thrift subprime borrowers who purchased a home in 2007, an estimated Supervision [OCC and OTS] 2010; Streitfeld 2010). 37 percent were in a negative equity position by mid-2009 (U.S. Historically, homeowners have faced foreclosure because they GAO 2009). And by the third quarter of 2009, 12.5 percent of experienced an income shock, such as job loss, which rendered borrowers (more than 10 million homeowners) were underwater them unable to continue making monthly mortgage payments. by more than 20 percent, with nearly half underwater by more What makes this housing crisis unique is that the unprecedented than 50 percent (Bernard 2010). foreclosure rates are driven by a more complicated mechanism. Through mid-2006, both rapid expansion in the subprime Negative equity and mortgage default mortgage market and declines in bank underwriting standards Homeowners with negative equity are more likely to default made mortgages accessible to many borrowers with weak credit on their mortgages – even in the absence of financial hardship histories and insufficient (or unverified) income and assets – because mortgage repayment does not increase home equity. (Bhardwaj and Sengupta 2008). Additionally, the new availability Although there are no systematic data on the proportion of of mortgage products – such as interest-only loans and 80/20 underwater mortgages in default, there is compelling evidence loans with no down payment combined with rapid housing that the two are strongly related. A recent study by First price appreciation to encourage increased debt among borrowers American CoreLogic (2010) finds that homeowners default on hoping to refinance into lower cost mortgages, once the home had their primary residential mortgages at the same rate as investors appreciated sufficiently or interest rates had dropped (Edmiston in rental properties, that is, once their homes are underwater by and Zalneraitis 2007). 25 percent or more, or the mortgage balance is $70,000 higher These mortgage market trends made borrowers particularly than the property value. An estimated 5-10 million homeowners vulnerable to interest rate increases and declining housing prices. In have reached this threshold (Bernard 2010; Streitfeld 2010). mid-2006, as housing prices began to decline amid rising interest Consultants at Oliver Wyman recently estimated that nearly rates and credit markets tightened, homeowners found themselves 17 percent of homeowners who defaulted in 2008 chose to do unable to refinance out of high-cost mortgages, especially if their so because their homes were underwater, rather than because of home was now worth less than their mortgage. The inability financial hardship (Streitfeld 2010). to refinance was particularly problematic for homeowners with Underwater mortgages in default resolve through one of variable-rate and interest-only mortgages,who could no longer three ways: afford the monthly payment after the mortgage reset at a higher • Mortgage cure (becoming current on the mortgage through rate. repayment or loan renegotiation), A sizable portion of mortgage defaults are among • (selling an underwater home in default at a loss, in underwater homeowners, and, as real estate prices continue to Short sale some cases with the lender’s consent to forgive the difference fall, homeowners are further underwater than ever. By the end of between the sale price and the mortgage amount), and 2006 approximately 7 percent of homeowners were underwater (Calculated Risk 2007); the figure reached 15-20 percent by 2008 • Foreclosure (property repossession by the lender). (Bernanke 2008; Hagerty and Simon 2008). The most recent In the case of short sale and foreclosure, borrowers with other estimates of underwater mortgages are staggering: Some claim assets may be held liable for loan amounts not covered by the that 11 million (one in five) U.S. households with mortgages are short sale or foreclosure. Short sale figures are one indicator of currently underwater (eCredit Daily 2010; Streitfeld 2010), while the pervasiveness of underwater mortgages in default. In January 2010, 15.9 percent of all home purchases resulted from short sales mortgage-backed securities – have done little to curb mortgage (Hoak 2010). Current estimates from real estate Website, Zillow. delinquencies. com, report that between 28.5 and 33 percent of homes sell at a The Obama Administration’s $275 billion Home Affordable loss, though loss sales are not always short sales (Zillow.com 2010; Modification Program (HAMP) is a more direct intervention, Haviv 2010). aimed at reducing foreclosures by providing incentives to lenders to make more affordable modifications to mortgages. The Who is underwater? HAMP program has drawn criticism for its stringent eligibility Homeowners relying either on subprime or reduced restrictions; narrow reach, with some estimating the program documentation mortgages (called “Alt-A,” for “Alternative-A assists fewer than 4 percent of borrowers who are more than 60 days paper”) are heavily exposed to mortgage defaults and negative delinquent; lengthy processing time; evidence of disparate impact, equity. The U.S. Government Accountability Office provides the with white HAMP-eligible borrowers more likely to receive following estimates of underwater mortgage status: loan modifications than minority HAMP-eligible borrowers; and • 63 and 57 percent of subprime and Alt-A borrowers, re-default rates of more than 50 percent among loans modified respectively, through HAMP and other loan servicer programs (Daly 2010; OCC and OTS 2010; National Community Reinvestment • 80 percent of nonprime borrowers with variable payment Coalition 2010). mortgages, which include interest-only loans, and In a recent New York Times op-ed, John Geanakoplos and • 75 percent of nonprime borrowers with short-term hybrid Susan Koniak (2009) argue that the federal government’s efforts adjustable rate mortgages (U.S. GAO 2009). to curtail foreclosures won’t work for underwater borrowers, who A recent Massachusetts-based study found that homeowners will continue to default on their mortgages as long as the principal who purchased condominiums and multi-family dwellings – balance is higher than the value of their home. They claim that often used as investment income properties – are more likely to be bailing out underwater mortgages by forgiving loan principal underwater and in default, in comparison to the overall borrower is a less costly, more effective alternative to loan modification population. The same study also found that negative equity programs. disproportionately affects low- and moderate-income borrowers, There is a growing realization among federal policymakers, who may have purchased homes beyond what they could afford mortgage lenders, and servicers, as well as underwater borrowers (Foote, Gerardi, and Willen 2008). themselves, that existing loan modification programs are Underwater mortgages are also concentrated geographically insufficient and only more drastic measures will stem the surge in in real estate markets that experienced the highest appreciation mortgage defaults. Yet questions remain about how best to solve rates during the housing boom. As of the fourth quarter of 2009, the problem, and whether taxpayers will be able to stomach the 70 percent of properties with mortgages were underwater in cost of additional loan modification programs. In late March 2010, Nevada, followed by 51 percent in Arizona, 48 percent in Florida, Bank of America announced the nation’s first major principal 39 percent in Michigan, and 35 percent in California (First forgiveness program, aimed at borrowers who are more than 20 American CoreLogic 2010). percent underwater (Harney 2010). That same week, the Treasury Department announced that up to $14 billion in TARP funds The federal policy response would help to write down principal on underwater mortgages In large part, the federal policy response to the mortgage backed by the Federal Housing Administration (Kilgore 2010). crisis has aimed at stabilizing the financial sector. As such, the Whether these new programs are effective – or induce moral Emergency Economic Stabilization Act of 2008 (the “Wall hazard by creating additional incentives for borrowers to default, Street Bailout”) and subsequent creation of the Troubled Asset as some critics warn – remains to be seen. Relief Program (TARP) – which authorizes and oversees the federal government’s purchase of up to $700 billion in illiquid References April 20, 2010, from http://www.washingtonpost.com/wp-dyn/content/ Bernanke, B.S. (2008, December 4). Housing, mortgage markets, and article/2010/03/26/AR2010032604817.html foreclosures. Speech presented at the Federal Reserve System Conference Haviv, J. (2010, February 10). RPT-One in five U.S. mortgages on Housing and Mortgage Markets, Washington, D.C. Retrieved April “underwater” in Q4 – Zillow. Reuters. Retrieved April 20, 2010, from 20, 2010, from http://www.federalreserve.gov/newsevents/speech/ http://www.reuters.com/article/idUSN0914378220100210 bernanke20081204a.htm Hoak, A. (2010, March 14). New program to speed ‘short’ sales. The Wall Bernard, T.S. (2010, April 2). Help paying mortgages elicits anger. The Street Journal. Retrieved April 20, 2010, from http://online.wsj.com/ New York Times. Retrieved April 20, 2010, from http://www.nytimes. article/SB126852717191861875.html com/2010/04/03/your-money/03money.html?hp Kilgore, A. (2010, March 26). FHA mortgage workout lacks incentives Bhardwaj, G. and Sengupta, R. (2008). Where’s the smoking gun? A and creates problems: Industry sources. Housing Wire. Retrieved April study of underwriting standards for U.S. subprime mortgages. Federal 20, 2010, from http://www.housingwire.com/2010/03/26/new-fha- Reserve Bank of St. Louis Working Paper, 2008-036. Retrieved April 20, mortgage-workout-option-lacks-incentives-and-creates-problems- 2010, from http://ideas.repec.org/p/fip/fedlwp/2008-036.html industry-sources/ Calculated Risk. (2007, December 4). Homeowners with negative National Community Reinvestment Coalition. (2010). HAMP mortgage equity. Message posted to http://www.calculatedriskblog.com/2007/12/ modification survey 2010. Retrieved from http://www.ncrc.org/images/ homeowners-with-negative-equity.html stories/mediaCenter_reports/hamp_report_2010.pdf Christie, L. (2010, February 25). Duck! Watch out for falling home Office of the Comptroller of the Currency and Office ofThrift prices. CNNMoney.com. Retrieved April 20, 2010, from http://money. Supervision [OCC and OTS]. (2010, March). OCC and OTS mortgage cnn.com/2010/02/25/real_estate/home_price_forecast/index.htm metrics report: Disclosure of national bank and federal thrift mortgage Daly, C.B. (2010, April 14). U.S. watchdog says mortgage modifications loan data, fourth quarter 2009. Washington, D.C. Retrieved April 20, too slow. Reuters. Retrieved April 20, 2010, from http://www.reuters. 2010, from http://www.ots.treas.gov/_files/482126.pdf com/article/idUSTRE63D0JJ20100414 Streitfeld, D. (2010, March 25). U.S. plans big expansion in effort to aid eCredit Daily. (2010, February 12). Negative equity crisis: Harbinger homeowners. The New York Times. Retrieved April 20, 2010, from http:// of foreclosures to come? eCreditDaily.com. Retrieved April 20, 2010, www.nytimes.com/2010/03/26/business/26housing.html?fta=y from http://ecreditdaily.com/2010/02/negative-equity-crisis-harbinger- The Economist. (2010, March 31). A splash of good news? The government foreclosures/ tries a new tack in the fight against mortgage foreclosures. Retrieved Edmiston, K.D. and Zalneraitis, R. (2007). Rising foreclosures in the April 20, 2010, from http://www.economist.com/business-finance/ United States: a perfect storm. Federal Reserve Bank of Kansas City Economic displaystory.cfm?story_id=15819275 Review, 92(4), 111 – 141. U.S. Government Accountability Office [U.S. GAO]. (2009, December First American CoreLogic. (2010, February 23). Media alert: Underwater 16). Loan performance and negative equity in the nonprime mortgage mortgages on the rise according to First American CoreLogic Q4 2009 market. Washington, D.C. Retrieved April 20, 2010, from http://www. negative equity data. Retrieved from http://www.loanperformance.com/ gao.gov/new.items/d10146r.pdf infocenter/library/Q4_2009_Negative_Equity_Final.pdf Zillow.com. (2010, April 3). Real estate market reports: Zillow home Foote, C., Gerardi, K., and Willen, P. (2008). Negative equity and value index. Retrieved April 20, 2010, from http://www.zillow.com/ foreclosure: Theory and evidence (Public Policy Discussion Paper No. local-info/ 08-3, Federal Reserve Bank of Boston). Retrieved from http://www.bos. frb.org/economic/ppdp/2008/ppdp0803.pdf Foote, C., Gerardi, K., Goette, L., and Willen, P. (2008). Just the facts: An initial analysis of subprime’s role in the housing crisis. Journal of Housing Economics, 17(4): 291-305. Geanakoplos, J.D. and Koniak, S.P. (2009, March 4). Matters of principal. Each issue of SPEA Insight highlights a major public policy The New York Times. Retrieved April 20, 2010, from http://www.nytimes. com/2009/03/05/opinion/05geanokoplos.html challenge in the USA or the world, along with analysis by SPEA Hagerty, J.R. and Simon, R. (2008, October 10). Nearly 1 in 6 homeowners faculty and other experts that will help policy makers address ‘underwater.’ The Wall Street Journal. Retrieved April 20, 2010, from these challenges. http://articles.moneycentral.msn.com/Banking/HomeFinancing/ nearly-1-in-6-homeowners-underwater.aspx Harney, K.R. (2010, March 27). Principal forgiveness program may www.spea.indiana.edu offer relief for underwater homeowners. The Washington Post. Retrieved